How to Run a SaaS Business During Inflation

I’ll start with the basics, then work up to how one man­ages a busi­ness dur­ing infla­tion­ary (or poten­tial­ly infla­tion­ary) times. I’ll sac­ri­fice tech­ni­cal accu­ra­cy for the sake of greater con­cep­tu­al under­stand­ing.

WHAT IS INFLATION?

First, infla­tion is the phe­nom­e­non of prices of goods and ser­vices increas­ing across an econ­o­my. It is prob­lem­at­ic because it intro­duces pric­ing insta­bil­i­ty in the econ­o­my.

Let me give you an exam­ple. I hap­pened to vis­it Turkey in 2001. In 2001 and for many years pri­or, Turkey had expe­ri­enced infla­tion rates rang­ing from 50% to 100%.

This had sev­er­al tan­gi­ble effects.

First, if you go into any retail store in Istan­bul, the items have no price tags. When I first saw this, I thought it was odd. How do you know how much it costs? You have to ask… for every item.

When I asked why, I was told it was because COGS (cost of goods sold) would change each week. COGS would increase. This would com­press mar­gins, mak­ing every prod­uct that was priced based on last week’s rate unprof­itable this week. Mer­chants got tired of revis­ing all the price tags on the shelf every few days, so they just removed all price tags.

The sec­ond thing I noticed was how many par­tial­ly built homes there were in the Turk­ish coun­try­side with no con­struc­tion crews work­ing on them. These were homes that had fram­ing and lum­ber but no walls and no roof.

Ini­tial­ly, I thought this was sim­ply a work in progress. How­ev­er, I noticed every home I saw was like this. I was con­fused. So, I asked why.

It turns out that mort­gage rates in Turkey were about 250%. That means that on a Turk­ish mort­gage equiv­a­lent of 100,000 USD, your prin­ci­pal bal­ance after your first year was 350,000 USD. In effect, nobody bor­rowed any mon­ey. Because there was no financ­ing, there was no res­i­den­tial con­struc­tion.

As you can see, infla­tion does some real­ly odd things in an econ­o­my. It’s a mas­sive dis­tor­tion that cre­ates a lot of uncer­tain­ty.

Now, let’s talk about what caus­es infla­tion, what sus­tains infla­tion, what some pos­si­ble infla­tion sce­nar­ios are in the U.S., and what con­tin­gency plans you want to have at the ready, depend­ing on what hap­pens.

WHAT CAUSES INFLATION?

Infla­tion is caused by two things:

1. Pre-exist­ing infla­tion (Let’s call this momen­tum infla­tion.)
2. Trig­gers that cre­ate infla­tion ini­tial­ly (Let’s call this root-cause infla­tion.)

Infla­tion Cause #1: Pre-Exist­ing Infla­tion (a.k.a. Momen­tum Infla­tion)

So, the #1 cause of infla­tion today is infla­tion yes­ter­day. Yes, let me repeat that because it is the thing to appre­ci­ate about infla­tion that most peo­ple don’t get.

Infla­tion exists (and per­sists) because it already exists.

If that sounds a bit cir­cu­lar, it’s because it is. Infla­tion is a self-rein­forc­ing cycle.

Let me explain how this plays out prac­ti­cal­ly.

Let’s say there’s an increase in COGS. You think, “I’m a SaaS com­pa­ny. My mar­gins are high. I’m not buy­ing phys­i­cal goods. It doesn’t apply to me.” You’re wrong.

Here’s why.

Let’s say that a man­u­fac­tur­er has increased costs for raw mate­ri­als, ener­gy, and trans­porta­tion. What do they do? Ini­tial­ly, they might absorb the cost, but even­tu­al­ly, they’ll have to raise prices (or go bank­rupt). So, they raise prices.

Now every man­u­fac­tur­er is under the same pres­sure, so they do it too.

Then, when your employ­ees go to buy gro­ceries and house­hold goods, prices are now high­er. Hmm… Over time, they find they can’t buy as much as they used to. There’s one solu­tion to this. They legit­i­mate­ly need a raise to make ends meet.

So, they demand a raise from you. I’m not say­ing an employ­ee demands a raise from you… they all demand rais­es from you at the same time.

What are you going to do?

You can’t lose all of your staff.

At some point, you have to increase your com­pen­sa­tion costs. If you do, your mar­gins get com­pressed. If the infla­tion is severe enough — and depend­ing on how much cash reserves you have and are will­ing to use — at some point, you’ll have to raise prices too.

Now all of your cus­tomers have high­er prices from their raw goods sup­pli­ers, from their employ­ees, and from you too. They recal­cu­late their finan­cial fore­cast, and they real­ize that the math doesn’t work. They need to get ahead of this, oth­er­wise, they’ll get squeezed.

So rather than react to input cost esca­la­tion after the fact, they decide to be proac­tive by rais­ing prices now to get ahead of the curve.

Now, the things your employ­ees buy at the store and Ama­zon are get­ting a lot more expen­sive quick­ly. This is crazy. Rather than get squeezed after the fact, they decide they need to be proac­tive too. They decide to ask you for anoth­er raise, and this time, a big­ger one.

Again, it’s not just one employ­ee who does this, it’s all of them… at the same time. Of course, you’re not dumb. You see the writ­ing on the wall… so you get proac­tive too.

This is momen­tum infla­tion at its worst. Once infla­tion gets going, it’s very hard to stop. (More on how gov­ern­ment pol­i­cy can stop infla­tion in a moment.)

Infla­tion Cause #2: Trig­gers that Cause Ini­tial Infla­tion (a.k.a. Root-Cause Infla­tion)

So now, let’s talk about the oth­er trig­gers of infla­tion — the two “root-cause” trig­gers of ini­tial infla­tion.

Root-cause infla­tion is a byprod­uct of using cur­ren­cy (U.S. dol­lars, euro, yen) for trade.

Pri­or to the inven­tion of cur­ren­cy, peo­ple con­duct­ed com­merce. They trad­ed goods.

I will trade you two cows for a two-seat license to your SaaS app. (Well, maybe not exact­ly like that, but you get the idea. )

In a barter econ­o­my, there is no such thing as infla­tion. There is only sup­ply and demand.

If there is a short­age of cows, the price for cows goes up. Most peo­ple get the idea of sup­ply and demand. It makes intu­itive sense.

Things are dif­fer­ent when cur­ren­cy is involved.

Currency’s orig­i­nal pur­pose was con­ve­nience.

It’s hard to car­ry a cow around if you want to buy some let­tuce at the mar­ket. It’s hard to sell only part of a cow. It’s hard to make change when some­one gives you a cow for some let­tuce, and you owe them 98% of a cow.

Orig­i­nal­ly, the amount of cur­ren­cy in a sys­tem was fixed.

The num­ber of dol­lars, euros, or yen in an econ­o­my did not orig­i­nal­ly change.

In such a sys­tem, prices only reflect­ed sup­ply ver­sus demand. A cow short­age still makes the price of a cow go up. That price increase is now com­mu­ni­cat­ed in dol­lars, euros, or yen.

Where things get weird is when the amount of cur­ren­cy in an econ­o­my isn’t fixed. When the sup­ply of cur­ren­cy increas­es, prices are adjust­ed not because of changes in sup­ply and demand but because of changes in the cur­ren­cy in cir­cu­la­tion.

In the barter econ­o­my, let’s say that one cow is trad­ed for one stor­age shed.

1 cow = 1 stor­age shed

In an econ­o­my with a fixed cur­ren­cy sup­ply, a cow might be priced at $1,000. A stor­age shed might also be worth $1,000.

The rel­a­tive val­ue of a cow and a stor­age shed are still the same.

A $1,000 cow = A $1,000 stor­age shed

Now, this is where things get inter­est­ing.

Let’s say that the gov­ern­ment decides to mint more coins or print more paper cur­ren­cy. There is now twice as much cur­ren­cy in the local econ­o­my as there was before. What is a cow worth? What’s a stor­age shed worth?

The cow is now worth $2,000. The shed is now priced at $2,000.

How­ev­er… and this is impor­tant… the rel­a­tive price between the cow and stor­age shed is still the same.

A $2,000 cow = a $2,000 stor­age shed

Even though the prices dou­bled, the actu­al rel­a­tive val­ue is the same.

This is, in fact, one of the two root caus­es of infla­tion: an increase in cur­ren­cy or mon­ey sup­ply.

As a result, one of the two root caus­es of infla­tion is the increase in the mon­ey sup­ply. (This is also known as mon­e­tary stim­u­lus.)

In gov­ern­ments around the world, there’s one insti­tu­tion that has the pow­er to increase the mon­ey sup­ply. They are the cen­tral banks. In the Unit­ed States, the cen­tral bank is known as the Fed­er­al Reserve.

When the Fed­er­al Reserve wish­es to stim­u­late the econ­o­my, they have a mech­a­nism by which they increase the mon­ey sup­ply. If you hear terms like “Fed­er­al Reserve open mar­ket oper­a­tions,” “quan­ti­ta­tive eas­ing,” or “mon­e­tary pol­i­cy,” these refer to the mech­a­nism by which the mon­ey sup­ply is increased.

To over­sim­pli­fy a bit, the Fed­er­al Reserve tells all the banks in the U.S. that they are will­ing to lend them huge amounts of mon­ey at very low (and even 0%) inter­est rates. The banks take the Fed up on this offer. The banks now have a ton of cash in their reserves at low costs. They then lend the mon­ey out to you and me as mort­gages, car loans, cred­it cards, and the like.

(Note: The Fed­er­al Reserve is the only enti­ty in the Unit­ed States that has a “check­ing account” with an unlim­it­ed bal­ance. It can trans­fer unlim­it­ed funds to com­mer­cial banks.)

Since the bank bor­rows from the Fed at real­ly low inter­est rates, the banks, in turn, can lend to you and me at low inter­est rates too and still make mon­ey.

Tra­di­tion­al­ly, the idea was that in a reces­sion, the Fed­er­al Reserve would stim­u­late the econ­o­my in this way to com­pen­sate for a short­fall in demand due to a reces­sion. As the econ­o­my recov­ers, the Fed­er­al Reserve revers­es what it did dur­ing the reces­sion. They pull back these efforts.

The idea was that this would allow for smoother eco­nom­ic cycles. The reces­sions would not be as harsh. The booms would be slight­ly less vig­or­ous. How­ev­er, the Fed’s ten­den­cy has been to pro­vide such stim­u­lus in all types of eco­nom­ic envi­ron­ments.

This kind of mon­ey sup­ply or mon­e­tary stim­u­lus in all envi­ron­ments con­tributes to infla­tion­ary risk.

If you think about it, it makes sense. If you can now buy a car with $0 down and a 1% inter­est rate, why not buy a new car? If you can buy a house at 2.5% inter­est, why not buy a new one? Etc.

The sec­ond root cause of infla­tion is increased spend­ing by the fed­er­al gov­ern­ment. (This is also known as fis­cal stim­u­lus.)

In a reces­sion, it can make sense for the fed­er­al gov­ern­ment to step up its spend­ing to make up for spend­ing short­falls by busi­ness­es and con­sumers. This is known as fis­cal pol­i­cy.

The the­o­ry is that the gov­ern­ment spends more in a reces­sion, then when con­sumers and busi­ness­es are spend­ing like crazy, the gov­ern­ment pulls back spend­ing. This, too, makes the bot­tom of reces­sions less painful and the peak of boom times slight­ly less vig­or­ous.

How­ev­er, in the Unit­ed States, our fed­er­al gov­ern­ment tends to spend a lot in all times — good times and bad.

In a reg­u­lar busi­ness, with­out ven­ture cap­i­tal and debt lines, you only sur­vive by spend­ing less than what you make in rev­enue. When sales exceed costs, you’re prof­itable. When costs are greater than rev­enues, we busi­ness­peo­ple call that being unprof­itable.

The U.S. gov­ern­ment is high­ly unprof­itable. It spends way more than it receives in tax rev­enue. Going back decades, every pres­i­dent has done this. Leg­is­la­tors from both par­ties do this. They can’t help it. It is just too tempt­ing to spend a lot of mon­ey to make your vot­ers hap­py so they re-elect you.

In nor­mal years, the U.S. gov­ern­ment is unprof­itable. In cri­sis years, it’s even more unprof­itable. This occurs when the gov­ern­ment bor­rows even more so it can spend mon­ey it does not have.

The obvi­ous ben­e­fit is the increased demand that allows busi­ness­es to have more mon­ey to pay employ­ees. The less-obvi­ous down­side is that this con­tributes to infla­tion risk and infla­tion itself. Here’s why.

When demand goes up, but sup­ply is fixed, prices go up. When the fed­er­al gov­ern­ment spends tril­lions more in a par­tic­u­lar year than it nor­mal­ly does, that’s extra demand. It puts upward pres­sure on prices. Sud­den­ly, there are more peo­ple with more mon­ey who want to buy more “cows,” and there aren’t enough cows to go around. Prices go up as a result.

So, the com­bi­na­tion of mon­e­tary pol­i­cy and fis­cal pol­i­cy, increas­ing the mon­ey sup­ply and increas­ing gov­ern­ment spend­ing, is a dou­ble wham­my that caus­es upward pres­sure on prices.

HOW TO MEASURE INFLATION

There are two ways to mea­sure infla­tion.

1. Infla­tion of Con­sum­ables
2. Infla­tion of Assets

The first is to track the prices of things peo­ple con­sume. My unof­fi­cial term for this is “infla­tion of con­sum­ables” (e.g., bread, eggs, milk, elec­tric­i­ty, gaso­line, etc.).

This first type of con­sum­ables infla­tion is what most peo­ple think of when it comes to infla­tion. In the Unit­ed States, it is mea­sured by some­thing called the Con­sumer Price Index (CPI). Most coun­tries have some ver­sion of this index. The CPI is a for­mu­la that takes the cur­rent prices of com­mon­ly con­sumed goods (e.g., gro­ceries, elec­tric­i­ty, gaso­line) and cre­ates a score. This score is used to gauge the change in prices from one month, year, or decade to the next.

When I was a kid, ice cream was $0.25 to $0.50 for a scoop. Today, it might cost $4.00 a scoop. The dif­fer­ence between the two reflects the infla­tion of the ingre­di­ents to make ice cream (cream, sug­ar, etc.).

The sec­ond type of infla­tion is asset infla­tion. Most peo­ple do not think of increas­es in asset prices as infla­tion. Assets include stocks, bonds, sin­gle-fam­i­ly homes, and cars.

When con­sumers have a lot of mon­ey from either near-inter­est-free debt (think: home mort­gage, car loan, cred­it cards) or fis­cal stim­u­lus (abnor­mal­ly high gov­ern­ment spend­ing in a vari­ety of forms that even­tu­al­ly ends up in con­sumers’ hands), they deploy it. There are real­ly two pri­ma­ry things con­sumers can do with extra cash. They buy things they con­sume (which is tracked by con­sump­tion infla­tion), or they buy assets that are more durable (homes, cars, stocks).

As a result, things like the S&P 500 stock mar­ket index are, in part, a mea­sure of infla­tion. The Case-Shiller Home Prices Index that mea­sures the aver­age price of a home in the Unit­ed States is also, in part, a mea­sure of infla­tion. If you track the prices of new and used cars, that is a mea­sure too. When you look at the val­u­a­tions of every asset class, and all of them are at record highs, that can be a sign of asset infla­tion.

Now that you have a base­line under­stand­ing of how infla­tion works, let’s focus on how this impacts your SaaS busi­ness, how you should pre­pare for infla­tion, and how you should respond after it hits.

HOW INFLATION IMPACTS YOUR BUSINESS

Infla­tion impacts four parts of your busi­ness:

1. Expens­es
2. Sales
3. Debt
4. Equi­ty

1. Expens­es

As you might intu­itive­ly guess, infla­tion increas­es your expens­es. Every­thing from phys­i­cal goods to labor costs tend to go up. Increased expens­es put down­ward pres­sure on mar­gins and on EBITDA (earn­ings before inter­est, tax­es, depre­ci­a­tion, and amor­ti­za­tion) or oper­at­ing prof­it… espe­cial­ly if the prices you charge do not go up at the same or greater per­cent­age.

(Remem­ber, even if you’re not buy­ing phys­i­cal goods, your sup­pli­ers and employ­ees like­ly do. To cov­er the increas­es in their phys­i­cal good costs, they’ll demand high­er wages or prices.) While this is not an overnight process, it can be a very real prob­lem with poten­tial­ly dev­as­tat­ing con­se­quences.

To under­stand why, we have to look at sales.

2. Sales

In nor­mal years, it’s advan­ta­geous to have your clients sign long-term con­tracts. This reduces churn, increas­es net rev­enue reten­tion, and gen­er­al­ly increas­es enter­prise val­ue as a result. How­ev­er, in infla­tion­ary envi­ron­ments, fixed-rev­enue con­tracts can be dan­ger­ous as they col­lide with ris­ing costs (due to infla­tion).

Cus­tomers often buy into long-term con­tracts to be guar­an­teed fixed prices and thus pre­dictabil­i­ty for their bud­gets. When your prices stay flat because of fixed con­tracts but your sup­pli­ers’ prices rise sig­nif­i­cant­ly, what hap­pens is that your prof­it mar­gins shrink.

This is how a busi­ness can go under in an infla­tion­ary envi­ron­ment.

There are two solu­tions to this prob­lem.

First, you nev­er want to have tru­ly fixed-price con­tracts. At a min­i­mum, you want to have some kind of auto­mat­ed, infla­tion-based price increase includ­ed in your con­tract. Many SaaS con­tracts have an auto­mat­ic 3% price increase includ­ed. It’s often around 3% for a few rea­sons. First, his­tor­i­cal­ly the Con­sumer Price Index runs around 3% per year. Sec­ond, cus­tomers and their legal coun­sel know this, so when they see a 3% price increase, they per­ceive that as nor­mal and just the price of doing busi­ness.

How­ev­er, if infla­tion were to rise to 7%, 10%, 15%, or more, the dif­fer­ence between the infla­tion rate and your auto­mat­ed price increas­es gets tak­en out of your prof­it mar­gins.

If infla­tion looks tem­po­rary and mod­est, a numer­i­cal­ly defined annu­al price increase (like 3%) is prob­a­bly fine. You take the hit for a few quar­ters or a year or two, and hope­ful­ly, things get back to nor­mal.

How­ev­er, the longer infla­tion per­sists and the greater the degree of infla­tion, the more a fixed-price-increase clause (espe­cial­ly one around 3%) becomes a prob­lem. Let’s look at a more extreme exam­ple.

To keep the math sim­ple, let’s say your annu­al con­tract val­ue (ACV) is $100 and a three-year term with a 3% auto­mat­ic price esca­la­tor.

This is your ARR for the dura­tion of the con­tract:

Year 1: $100 ARR
Year 2: $103 ARR
Year 3: $106 ARR

Let’s say you’re in growth mode and run the entire busi­ness at a 0% EBITDA mar­gin. Basi­cal­ly, you break even.

In a nor­mal infla­tion­ary envi­ron­ment, this is what your per account P&L looks like when you expect your own sup­pli­ers to raise prices by 3%.

Year 1: $100 ARR — $100 Costs = $0 Prof­it (0% Prof­it)
Year 2: $103 ARR — $103 Costs = $0 Prof­it (0% Prof­it)
Year 3: $106 ARR — $106 Costs = $0 Prof­it (0% Prof­it)

Now let’s say that infla­tion runs at 15%. Let’s recal­cu­late the three-year account-lev­el P&L:

Year 1: $100 ARR — $115 Costs = -$15 Prof­it (-15% Prof­it)
Year 2: $103 ARR — $132 Costs = -$29 Prof­it (-28% Prof­it)
Year 3: $106 ARR — $152 Costs = -$46 Prof­it (-43% Prof­it)

• Like inter­est rates, infla­tion com­pounds… and when it does, it is bru­tal.

Three years at 15% infla­tion is dev­as­tat­ing to prof­its in this sce­nario.

There are a few solu­tions:

1. Steer away from long-term sales con­tracts in infla­tion­ary con­di­tions (for new cus­tomer acqui­si­tion and cus­tomer renewals).
2. Rewrite con­tracts to have a high­er annu­al price increase clause (for new cus­tomer acqui­si­tion and cus­tomer renewals).
3. Rewrite con­tracts to have annu­al price increas­es tied to some mea­sure of infla­tion like the CPI (Con­sumer Price Index), Wall Street Jour­nal Prime Rate, or LIBOR (Lon­don Inter­bank Offered Rate) (for new cus­tomer acqui­si­tion and cus­tomer renewals).

This doesn’t solve the prob­lem of exist­ing cus­tomers on long-term fixed-price or fixed-price-increase con­tracts, but at least you don’t make the prob­lem worse going for­ward.

3. Debt

Sce­nario A: Fixed-Rate Debt

If you have fixed-rate debt, infla­tion ben­e­fits you… espe­cial­ly if you’re able to raise prices.

Let’s say that you have a month­ly debt pay­ment of $100. In a typ­i­cal year, you receive an aver­age MRR (month­ly recur­ring rev­enue) of $100.

Month­ly debt ser­vice P&L:

MRR: $100
Debt Costs: -$100
———————————
Prof­it: $0

Let’s assume that you don’t have any long-term sales con­tracts. As infla­tion ris­es, you raise prices to match. Let’s fur­ther assume that infla­tion is 15% per year.

Here’s what a slight­ly over-sim­pli­fied P&L looks like:

Year 1:

MRR: $115
Debt Costs: -$100
———————————
Prof­it: $15

Year 2:

MRR: $132 ($100 x 115% x 115%)
Debt Costs: -$100
———————————
Prof­it: $32

Year 3:

MRR: $152 ($100 x 115% x 115% x 115%)
Debt Costs: -$100
———————————
Prof­it: $52

In this sce­nario, you’re get­ting arti­fi­cial rev­enue growth from infla­tion, but your debt pay­ments are fixed. This is an opti­mal sit­u­a­tion.

Sce­nario B: Vari­able-Rate Debt

While it is pos­si­ble to get bank loans with fixed inter­est rates, it’s far less com­mon to get that with ven­ture debt financ­ing. Most ven­ture debt financ­ing has an inter­est rate that “floats” with the pre­vail­ing inter­est rates of the day. You’ll see inter­est rates expressed on ven­ture debt term sheets as fol­lows:

Inter­est Rate = Wall Street Jour­nal Prime Rate + X%

The inter­est rate is expressed as “markup” (known as inter­est rate spread) over and above the cur­rent day’s pre­vail­ing inter­est rate. This type of struc­ture pro­tects lenders from infla­tion risk… and pass­es that risk back to you.

Vari­able-rate debt can be absolute­ly bru­tal in infla­tion­ary times. Here’s why. When infla­tion increas­es, so do inter­est rates.

Here’s an exam­ple.

Let’s say you have ven­ture debt financ­ing as fol­lows:

Inter­est Rate = Wall Street Jour­nal Prime Rate + 10%

In a low-infla­tion-rate, low-inter­est envi­ron­ment, the Wall Street Jour­nal Prime Rate is close to the infla­tion rate.

For argument’s sake, let’s say that a low-inter­est-rate, low-infla­tion-rate envi­ron­ment is one where infla­tion is 3% and the Wall Street Jour­nal Prime Rate is also 3%.

In this sce­nario, the inter­est rate on your ven­ture debt is 13%.

Ven­ture Debt Inter­est Rate = 3% Prime Rate + 10% Markup on Prime Rate = 13%

Now let’s say that infla­tion sky­rock­ets to 15%, and as a result, so does the Wall Street Jour­nal Prime Rate.

New Inter­est Rate = 15% (Wall Street Jour­nal Prime Rate) + 10% = 25% (Bru­tal!)

The effec­tive inter­est rate near­ly dou­bles, which ends up increas­ing month­ly debt ser­vice costs by about 24% (assum­ing a four-year, ful­ly amor­tiz­ing term).

An unex­pect­ed 24% increase in month­ly debt ser­vice in an envi­ron­ment where cus­tomers have a lot of macro­eco­nom­ic uncer­tain­ty adds even more pres­sure to your busi­ness.

If you have a lot of vari­able-rate debt financ­ing, unex­pect­ed ris­ing inter­est rates (from ris­ing infla­tion rates) can be dev­as­tat­ing.

Financ­ing Rules of Thumb dur­ing High Infla­tion:

• Fixed-Rate Financ­ing = Good
• Vari­able-Rate Financ­ing = Bad

4. Equi­ty

How infla­tion impacts equi­ty on the bal­ance sheet is unclear. For some busi­ness­es that take advan­tage of oppor­tu­ni­ties that only emerge dur­ing infla­tion­ary times, share­hold­ers can ben­e­fit. For oth­er com­pa­nies, infla­tion can severe­ly dam­age a business’s finances and thus its val­ue to equi­ty hold­ers.

To mas­sive­ly over­sim­pli­fy, busi­ness­es that can raise prices (and whose cus­tomers will tol­er­ate the price increase) tend to either do well or, at least, neu­tral dur­ing infla­tion­ary times. Busi­ness­es that are not able to do so tend to suf­fer.

Now let’s take a look at the oppor­tu­ni­ties that emerge or are unusu­al­ly ben­e­fi­cial dur­ing infla­tion­ary times.

OPPORTUNITIES IN INFLATIONARY ENVIRONMENTS

In addi­tion to the oppor­tu­ni­ties men­tioned above (bor­row­ing mon­ey with fixed and low inter­est rates), here are a few more oppor­tu­ni­ties to be aware of that become appeal­ing or more appeal­ing dur­ing infla­tion­ary times.

A. Lock­ing in Major Expens­es at Low, Fixed Prices (typ­i­cal­ly before high infla­tion kicks in)

If you see high infla­tion com­ing (cor­rect­ly and before oth­ers do), there can be an oppor­tu­ni­ty to nego­ti­ate long-term fixed-rate expense con­tracts. One exam­ple is real estate leas­es. As infla­tion increas­es, the inter­est rates that land­lords must pay in their debt ser­vices go up. This prompts them to raise rental rates to cov­er the high­er debt ser­vices. If you have a long-term lease with a fixed annu­al lease amount, in an infla­tion­ary envi­ron­ment, you ben­e­fit (and your land­lord suf­fers).

If the price of elec­tric­i­ty goes up sig­nif­i­cant­ly, and with it, the cost of cloud com­put­ing ser­vices that you rely on, then lock­ing in a fixed-price con­tract ear­ly can be ben­e­fi­cial.

How­ev­er, there is one major caveat: infla­tion tends to desta­bi­lize cus­tomers. Infla­tion tends to cre­ate unpre­dictabil­i­ty for busi­ness­es and their cus­tomers. When things are uncer­tain, it’s hard­er to plan. If demand for your offer­ings does not change and infla­tion is high, then lock­ing in long-term con­tracts is ben­e­fi­cial. How­ev­er, if infla­tion desta­bi­lizes and reduces cus­tomer demand for your offer­ings, then the last thing you want to do is get locked into a fixed long-term expense for a resource (like office spaces) that you don’t end up using. That’s not good either.

B. Sell­ing to Cus­tomers in For­eign Coun­tries with­out Infla­tion and Pric­ing in Local Cur­ren­cy

Anoth­er oppor­tu­ni­ty in infla­tion­ary times is to sell to inter­na­tion­al cus­tomers locat­ed in coun­tries with low infla­tion, price your offer­ings in the local cur­ren­cy, and retain your prof­its in the same cur­ren­cy.

Let me explain why.

Amer­i­cans under the age of 65 gen­er­al­ly have not oper­at­ed a busi­ness in an infla­tion­ary envi­ron­ment. All of their intu­itive eco­nom­ic life expe­ri­ence is premised on low infla­tion.

If you talk to any­one who lived in Turkey in 1994, Brazil in 1990, or Hun­gary in 1945 (where prices dou­bled — get this — every 15 hours, and the infla­tion rate was so high it was only expressed in sci­en­tif­ic nota­tion), they have com­plete­ly dif­fer­ent life expe­ri­ences.

What these peo­ple appre­ci­ate that Amer­i­cans don’t is that, in times of infla­tion, one’s cur­ren­cy gets deval­ued.

Let me explain with an exam­ple.

Let’s go back to our exam­ple of buy­ing a cow.

In a non-infla­tion­ary econ­o­my, 1 cow = $1,000

Or stat­ed in dif­fer­ent terms, a sin­gle dol­lar can buy 1/1,000th of a cow.

Let’s say that there’s 100% infla­tion.

1 cow = $2,000

That makes sense. Prices dou­bled.

But look at what hap­pens when we look at the pur­chas­ing pow­er of $1.

A year ago, $1 could buy 1/1,000th of a cow.

This year, $1 can only buy 1/2,000th of a cow.

The dol­lar is worth less with each pass­ing day.

With hyper­in­fla­tion, every per­son in that coun­try knows that you don’t want to hold your own cur­ren­cy. You don’t want it in your bank account. You don’t want it in your wal­let. You don’t want it stuffed under your mat­tress.

What every per­son in Turkey in 1994, Brazil in 1990, or Hun­gary in 1945 knew was that you des­per­ate­ly want­ed some oth­er country’s (more sta­ble) cur­ren­cy instead.

Here’s an exam­ple.

Let’s say that we are com­par­ing the price of a loaf of bread in the Unit­ed States to one in Europe.

Let’s also say that in nor­mal, low-infla­tion times, a loaf of bread in the Unit­ed States = a loaf of bread in Europe.

So, to over­sim­pli­fy a bit:

1 USD = 1 Loaf of Bread in U.S. = 1 Loaf of Bread in Europe = 1 Euro

One USD buys one loaf of bread in either coun­try. One euro does the same. Every­thing is equal to every­thing else.

Now let’s say that we have 100% infla­tion in the Unit­ed States, where­as Europe has no infla­tion. So, what hap­pens in this sce­nario?

As you might intu­itive­ly guess, the price of bread (in U.S. dol­lars) goes up.

2 USD = 1 Loaf of Bread in U.S. = 1 Loaf of Bread in Europe = 1 Euro

It takes two USD to buy a loaf of bread in either coun­try. How­ev­er, a loaf of bread is still worth a loaf of bread. And as such, one euro still buys a loaf of bread in either coun­try.

But with infla­tion, 1 USD only buys half of a loaf of bread.

So, how does the math work out this way?

Let’s think about it.

Back in the barter econ­o­my, a loaf of bread is worth a loaf of bread. Cur­ren­cy was sim­ply a more portable way to trans­act com­pared to stuff­ing your pock­ets full of mul­ti­ple loaves of bread.

When one coun­try has infla­tion, but anoth­er does not, the actu­al bread does not change. The use­ful­ness of the loaf of bread does not change. It still makes the same num­ber of sand­wich­es before and after infla­tion. What does change is the per­cep­tion of pric­ing.

Because of the intrin­sic val­ue of a loaf of bread, cur­ren­cy exchange rates shift to com­pen­sate for infla­tion.

In oth­er words, in non-infla­tion­ary times, 1 USD = 1 euro = 1 loaf of bread.

With 100% infla­tion, like the exam­ple above, 2 USD = 1 euro = 1 loaf of bread.

If there’s a sec­ond year of 100% infla­tion, then 4 USD = 1 euro = 1 loaf of bread.

If there’s a third year of 100% infla­tion, then 8 USD = 1 euro = 1 loaf of bread.

In year one, 1 USD = 1/2 of a loaf of bread.

In year two, 1 USD = 1/4 of a loaf of bread.

In year three, 1 USD = 1/8 of a loaf of bread.

Each year, the U.S. dol­lar buys less and less bread.

In con­trast, in Europe (in this hypo­thet­i­cal sce­nario), 1 euro = 1 loaf of bread across all three years.

So, this means that busi­ness­es in infla­tion­ary economies that export to oth­er coun­tries with low infla­tion do well. You ide­al­ly want to price your offer­ings in the local cur­ren­cy (euros, in this exam­ple). Even bet­ter would be to have your cash reserves, sav­ings, and check­ing accounts held in the same cur­ren­cy (euros, in this exam­ple).

[Side­bar: This has numer­ous cross-func­tion­al impli­ca­tions. Is your SaaS appli­ca­tion mul­ti­lin­gual, and does it offer local­iza­tion fea­tures? Do you have mul­ti­c­ur­ren­cy bank­ing fac­ul­ties set up? If you sell to the SMB mar­ket and take cred­it cards, is your cred­it card pro­cess­ing sys­tem able to take pay­ments in for­eign cur­ren­cies with­out auto­mat­i­cal­ly exchang­ing funds into U.S. dol­lars? Is your data stor­age archi­tec­ture com­pli­ant with oth­er coun­tries’ pri­va­cy laws? Do you have the capac­i­ty to gen­er­ate leads out­side the Unit­ed States? Do you have tech­ni­cal sup­port cov­er­age dur­ing busi­ness hours in the new coun­tries you might do busi­ness in? What sales capa­bil­i­ties do you have to sell into new geo­graph­ic mar­kets?

Would I exe­cute these deci­sions right now? No. Would I spend a few hours map­ping out a pre­lim­i­nary con­tin­gency plan? Yes. Would I research the plan more thor­ough­ly if and when infla­tion inten­si­fies? I would. Would I start build­ing mul­ti­lin­gual, mul­ti­c­ur­ren­cy option­al­i­ty into my tech and billing stack? I might look into the cost and fea­si­bil­i­ty of it. Would I keep a very sharp eye on var­i­ous infla­tion indi­ca­tors like the CPI and S&P 500? I absolute­ly would.]

These are the dynam­ics at play for busi­ness­es dur­ing high infla­tion. It’s a bit of a roller­coast­er.

But wait… there’s more… (the roller­coast­er ain’t over yet).

Let’s look at how infla­tion ends.

HOW GOVERNMENT POLICIES CAN END INFLATION

(And Why the “Cure” Can Be Worse than the “Dis­ease” for Busi­ness Own­ers)

As you can see, infla­tion, at best, cre­ates uncer­tain­ty, and at worst, cre­ates chaos. It’s desta­bi­liz­ing. If you don’t know what your sales and expens­es will be (as they get dis­tort­ed by infla­tion), then how do you plan?

Just as there were two under­ly­ing root caus­es to cre­at­ing infla­tion — increased mon­ey sup­ply and increased gov­ern­ment spend­ing — there are also two ways to stop it: a reduc­tion in the mon­ey sup­ply and a reduc­tion in gov­ern­ment spend­ing.

How­ev­er, it is not so sim­ple.

As I men­tioned pre­vi­ous­ly, the #1 cause of infla­tion today is infla­tion yes­ter­day. I called this momen­tum infla­tion. It turns out that momen­tum infla­tion is very tough to stop. Once every­one real­izes there’s infla­tion, then every play­er in an econ­o­my tries to get ahead of the curve. Com­pa­nies try to raise prices for cus­tomers before the company’s sup­pli­ers do the same to them. Employ­ees demand high­er wages as they antic­i­pate a loaf of bread that used to cost $5 will now cost $6 or $7.

Even if the gov­ern­ment pulls back from one-time spend­ing, that’s often not enough to stop the momen­tum and expec­ta­tions around antic­i­pat­ed infla­tion.

It turns out that the key lever to stop­ping infla­tion is to decrease the mon­ey sup­ply. The pri­ma­ry way this is done is by the cen­tral bank (in the Unit­ed States, that’s the Fed­er­al Reserve) rais­ing inter­est rates.

Think about it.

What hap­pens when inter­est rates go up?

If inter­est rates on mort­gages go up a lot, that’s going to cre­ate mas­sive mort­gage pay­ments. You’re not going to be so quick to buy a house and can no longer afford to offer over the ask­ing price to buy it. Hous­ing prices then come down.

If car loans are no longer 1% inter­est and are now, say, 5%, 10%, or 15% inter­est, con­sumers can’t afford car loan pay­ments that are 50% more than they used to be. So, they only buy cars that are priced low­er. Car prices come down as a result.

When your ven­ture debt financ­ing pay­ments sky­rock­et, sud­den­ly, you’re mas­sive­ly cash-flow neg­a­tive. You can’t afford to make pay­roll unless you do lay­offs. You do lay­offs. Your com­peti­tors do lay­offs too. Your sup­pli­ers do lay­offs. Your cus­tomers do lay­offs. With so many laid-off work­ers want­i­ng work and notic­ing how much com­pe­ti­tion there is for jobs, they’re will­ing to work for less mon­ey than they did before. Wages come down.

If cred­it card inter­est rates dou­ble, those cred­it card pay­ments bal­loon quick­ly. Con­sumers aren’t as quick to spend, so prices on con­sum­ables go down because there is less demand.

If this pat­tern sounds famil­iar, it’s because it is… It’s what hap­pens in a reces­sion.

Yes, the sure­fire cure for infla­tion is to delib­er­ate­ly cre­ate a reces­sion!

(I did say the roller­coast­er ain’t over yet, didn’t I?)

There’s a rea­son they call these things “busi­ness cycles” or “eco­nom­ic cycles.”

In prac­tice, cre­at­ing a reces­sion is not the hope and desired out­come of a cen­tral bank like the Fed­er­al Reserve. What the Fed does do is steadi­ly raise inter­est rates in order to sup­press demand. The tricky thing is that it’s hard to get the rate increas­es exact­ly right. If you raise inter­est rates too mod­est­ly and too late, infla­tion momen­tum takes over. If the Fed rais­es inter­est rates too much and too fast, they cre­ate a reces­sion.

So, the sweet spot for man­ag­ing inter­est rate increas­es (known as reduc­ing the mon­ey sup­ply) is to raise inter­est rates just enough to cool off crazy lev­els of spend­ing on con­sum­ables and pur­chas­ing of assets, but not so much as to cre­ate a reces­sion.

It is noto­ri­ous­ly dif­fi­cult to get exact­ly right.

What is true is that the greater the infla­tion and the stronger the infla­tion momen­tum, the more it makes sense to aggres­sive­ly raise inter­est rates (by rais­ing them a lot and doing it fast) and risk cre­at­ing a reces­sion. Reces­sions are bad, but run­away infla­tion is hor­ri­ble.

Once infla­tion momen­tum gets going, there are no good options — only bad out­comes and worse out­comes.

It’s a bit­ter pill to swal­low to inten­tion­al­ly cre­ate a bad out­come sole­ly to avoid a worse one.

Yes, ampu­ta­tion saves lives, but damn… I kind of like my limbs, you know what I mean?

So… what does this mean for you?

Two things:

1. You have to pre­pare con­tin­gency plans in case there’s per­sis­tent­ly high infla­tion.
2. You also have to pre­pare con­tin­gency plans in case there’s a reces­sion.

(I did say the cure can be just as bad as the infla­tion dis­ease, didn’t I?)

The key take­away here is con­tin­gency plans. You need to be pre­pared to adapt to a very wide range of pos­si­ble sce­nar­ios… and be able to adapt quick­ly.

If you’ve read this far (which if you have, I thank you, as I won­der whether any­one is actu­al­ly inter­est­ed in this stuff or if I’m typ­ing at 1:30 a.m. for no good rea­son), you’ve like­ly reached the same con­clu­sion that I’ve reached.

Infla­tion sucks.

It real­ly does.

It’s far eas­i­er to pre­vent infla­tion than it is to try to fix it once momen­tum kicks in. That said, you as a CEO can only con­trol what you can con­trol.

I hope this guide pro­vides you with a primer on how infla­tion works, what signs to look for, what threats to avoid, and what oppor­tu­ni­ties to con­sid­er.

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